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How I Created a Better Way to Choose Funds

Where fund screens fall short, the Fiduciary Scorecard can provide help

According to Morningstar, there are 22,689 mutual funds, 1,457 ETFs, 14,422 stocks, and I couldn’t even venture a guess as to the number of municipal, corporate and government securities on the market. Moreover, there are a number of additional investments such as UITs, CEFs, REITs, MLPs, tangible assets and more. For advisors, sifting through the multitude of information in the investment universe is a daunting task to say the least.

For advisors who use mutual funds and exchange-traded funds, this article should hold special interest. In it I will share a process that I began developing about four years ago. After much tweaking, it has been refined to a point where my ability to select and maintain high-quality funds has been greatly enhanced. I call this tool my Fiduciary Scorecard. Unlike the majority of programs used to select funds, the Fiduciary Scorecard utilizes a ranking system rather than the problematic screen.

Screens Have Holes

Most investment programs utilize screens. For example, let’s say you were searching for large-cap funds with a trailing one-, three- and five-year category rank in the top 50th percentile. Some funds may meet the criteria in two periods, but miss it in the third and would be eliminated. This is true even if a fund missed the third time period by only one percentage point. Screens will eliminate everything that doesn’t meet their strict guidelines. This may not pose a problem if your screen only contains one criterion, but if your screen includes multiple criteria, you could be eliminating many good funds.

Although my process begins with a screen, it is a very basic one. For example, I will screen for large-cap domestic value stocks with more than 80% invested in America. The result is a fairly large universe. Then, each fund is ranked by the Fiduciary Scorecard. In this way, a fund won’t be eliminated, but if it happens to be a regular visitor in the third or fourth performance quartile, it may receive a lower score.

The Score

When I embarked on my road to independence several years ago, I needed software to help with fund selection. Although most applied some sort of screen, there were a few outliers. One such tool was from Klein Decisions. Klein has developed a system whereby you can select the data you deem most relevant. Another program I especially liked was from fi360 that analyzed and scored funds according to fiduciary standards. Although both programs were good, being the financially frugal person I am and considering they used data I didn’t believe to be important, I decided to create an alternative.

When you consider the amount of information available, you quickly get a sense of the challenge one faces when selecting funds. In the course of my research, I discovered that some data is more important than others. This belief was reinforced after reading Russel Kinnel’s book, “Fund Spy.” Kinnel is the director of mutual fund research at Morningstar. He found certain data held greater significance in identifying future outperformers.

Portfolio Building

The process of building a portfolio of funds and ETFs involves three basic steps. First, you must identify which categories have the greatest potential to outperform given your particular global macro economic outlook. Next, you must search for the best funds and ETFs within these categories. Finally, you must determine the amount to be allocated to each fund. We will focus our attention on fund selection.

In the scoring process, each fund is measured against its specific peer group and not against the entire universe. Also, a fund with a higher score is preferred to a fund with a lower score and all data is from Morningstar.

The Five Broad Categories

There are five main areas included in a fund’s fiduciary score: absolute risk, relative risk, expense, stability and relative performance (See Figure 1, below). Let’s drill down and take a closer look at each category and how points are awarded.

Absolute Risk.Absolute risk is a measure of a fund’s fluctuation without regard to performance. To gauge a fund’s absolute risk over the past three and five years, I use standard deviation. If a fund’s standard deviation is 25% or more lower than its peer group average, it receives two points. If it is 0% to 24% below its category average, it receives one point. Otherwise, no points are awarded.

Absolute Risk’s contribution to final score: 6.6%.

Relative Return. Relative risk is a measure of how well a fund performs given the amount of risk it assumes. Funds with greater risk should compensate investors with a higher return. Each fund is ranked within its peer group on a risk-adjusted basis using Sharpe ratio, alpha, information ratio and risk/return.

Sharpe Ratio. The Sharpe ratio is a risk-adjusted measure used to determine an investment’s excess return per unit of risk. Its formula incorporates the standard deviation and the risk-free rate. If a fund’s Sharpe ratio is greater than the average for its category over the trailing three-year period, it receives four points. Otherwise, no points are assigned.

Alpha. Alpha can be useful in determining how much value a manager has added. Alpha is most useful when comparing funds with similar investment objectives. If a fund’s alpha exceeds its category average for the trailing three-year period, it receives four points. Otherwise, no points are awarded.

Information Ratio. Unlike the Sharpe ratio, this risk-adjusted ratio replaces standard deviation with a specific benchmark index. Because the IR is affected by a fund’s tracking error, and because I don’t believe tracking error is particularly useful, it receives a lower point total than the other relative risk measures. If a fund’s IR is above its peer group average for the trailing three-year period, it earns three points. Otherwise, no points are given.

Morningstar Risk/Return. Morningstar risk is an assessment of the variations in a fund’s monthly returns with an emphasis on downward variation. I’ll forgo divulging their secret sauce, but will mention that the top 10% of funds are given a risk score of five or “High”; the next 22.5% are scored four or “Above Average”; the next 35% are scored three or “Average”; the next 22.5% are scored two or “Below Average”; the bottom 10% are scored one or “Low.”

Morningstar return is an assessment of an investment’s excess return over a risk-free rate (e.g., the return of the 90-day Treasury bill), the results of which are similarly divided into one of the five aforementioned categories.

Using the trailing three- and five-year periods for each, here’s how I score them: Let’s assume a fund has a risk profile of Average. We would expect the return to be at least Average and hopefully higher. If a fund has a risk profile of Low and a return profile of High (the best possible outcome), the difference between the two is four sigma. In scoring, if there is four sigma difference, it receives the maximum number of points: five. If there is a three sigma difference, it receives four points, and so on. If the risk and return are equal, it receives one point. If, however, the risk is higher than the return (not desirable) no points are awarded.

Relative Risk’s total contribution to final score: 35%.

Expense. Morningstar analyzes several different expense ratios. I prefer to use the prospectus net expense ratio. This measures the percentage of fund assets paid for operating expenses and management fees. In contrast to the gross expense ratio, the net expense ratio reflects any fee waivers in effect during the time period. Therefore, I believe it to be a more accurate measure. If a fund’s expense ratio is more than 25% below its peer group average, eight points are assigned. If the ratio is 0% to 24% below, four points are awarded. Otherwise, no points are given.

Expense’s contribution to final score: 13.5%.

Stability. Stability is determined by the length of time the fund’s management has been in place. If a fund manager has been with the fund for 10 years or more, four points are awarded. Funds with management in place for five to nine years earn three points, and those with managers of three or four years receive two points. If a manager has been in place less than three years, no points are awarded.

Stability’s contribution to final score: 6.6%.

Relative Performance. The final area is relative performance, which includes category performance and category rank.

Category Performance. This category includes how well a fund’s returns compare with its category average over the trailing one-month, three-month, and most recent five calendar years. The one- and three-month returns have a lesser impact on the score than the calendar years. I also believe it’s important to evaluate a manager’s performance during difficult periods. Therefore, 2008 has a greater impact on the score than the other four calendar years.

If a fund’s return was greater than its category average for the one- or three-month period, one point is awarded. Two points are earned for above average returns in most calendar years with the exception of 2008, where four points is the maximum.

Category Rank. Morningstar ranks a fund’s performance in percentiles for various time periods. If a fund is ranked in the first percentile, then it has outperformed 99% of its peers. Conversely, a rank of 100 indicates it was at the very bottom of its peer group. I use the trailing one-, three- and five-year periods in my Scorecard. If a fund ranks in the top quartile, it receives three points. A second quartile fund earns two points and third quartile ranking gets one point. If a fund ranks in the bottom quartile, no points are awarded.

Relative Performance’s contribution to final score: 38.3%.

By using so many different points of data, each with a different weighting, knee-jerk reactions can be avoided.

The Fiduciary Scorecard and My Practice

As fiduciaries, we will be measured more on our process than absolute performance. In other words, “Was there a good reason to do what we did?” The Fiduciary Scorecard fits this need for a well-defined process perfectly. Once funds have been selected, monitoring becomes the key issue.

Fund Watch List

To monitor the funds I’ve selected, I download all funds held across all accounts from my custodian’s portal and run their score. If a fund has a fiduciary score of 75% or higher, it receives a rating of “Pass+.” Funds scoring between 50% and 75% are rated “Pass.” Funds from 40% to 49% are a “Watch One.” Funds that score between 30% and 39% are a “Watch Two,” and a score below 30% is a “Watch Three.” If a fund is a Watch One, no action is taken, but I will pay a little closer attention to it. If a fund falls to a Watch Two, I’ll phone the fund company and discuss it. If I believe the fund has a reasonably good chance of improving, I’ll hold it. If a fund falls to a Watch Three, it’s liquidated.

The Fiduciary Scorecard report includes the fund’s name and ticker symbol, its sub category, the total allocation I have in the fund, its fiduciary score and its broad ranking (see Figure 2, above). Another column displays the percentage of total possible data for the fund. For example, if a fund does not have a five-year track record, it won’t be penalized. The Scorecard will simply use the data it does have. However, if a fund has less than 50% of possible data, no score is awarded and “Insufficient Data” is displayed. The output is formatted as a table and, as such, can be sorted by any heading.

There’s one additional item of significance. If I held a fund with a low score and had a lot of client money in it, that would be a concern. It’s also important to know what percentage of funds are on the Watch List.

Account Reviews

The Fiduciary Scorecard has become a regular part of account reviews. Along with performance, composition, etc., I’ll include a Scorecard for the funds held in the client’s account. Clients appreciate the information, and it gives them a sense of security and comfort to know we have a good due diligence process in place. Clients can easily relate to a ranking system which ranges from. one to 100.

Even if you are not inclined to develop a similar system or pay the money to subscribe to one of the aforementioned products, it is still helpful to focus your search on the areas outlined above. Just be careful not to be too rigid with your screen.